An Introduction to Fraud Dr Richard G Brody

An Introduction to Fraud Dr. Richard G. Brody, CPA, CFE, CFF, FCPA Anderson School of Management Douglas Minge Brown Professor University of New Mexico

Estimated Costs/Impacts of Fraud Report to the Nation • $994 billion per year (2010 Global Estimate is more than $2. 9 trillion) • $6, 860 per employee • $18. 30 per day per employee • 5 - 7% of revenue lost • 5 - 7 cents on every revenue dollar stolen

The Seriousness of Fraud • How is the magnitude perceived to be changing? • Size and dollars • Effect on stock price • Collusion • Credibility issue

Fraud is a Costly Business Problem • Fraud reduces a firm’s • Fraud Robs Income net income on a dollar -for-dollar basis. • If the profit margin is 10%, revenues must increase by 10 times losses to recover the effect on net income. Revenues Expenses Net Income Fraud Remaining $100 90 $ 10 1 $ 9 100% 90% 10% To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.

What Does the Fraudster Look Like? • • Like you and me No specific psychological profile Male: U. S. 57%; Global 67% Occupational fraudsters are generally first-time offenders. – Only 7% of fraud perpetrators had prior convictions, and only 10% had been previously terminated by an employer for fraud-related conduct.

Seven Elements of Fraud 1. 2. 3. 4. A representation About a material point Which is false And intentionally or recklessly so 5. Which is believed 6. And acted upon by the victim 7. To the victim’s damage

Why Are We so Often Conned? • Trusting – we trust too much o Often a “I can’t believe it” response • Greed – rules many decisions o The perpetrator is not the only one

Ways to Classify Frauds • Fraud against an organization • Fraud on behalf of or for an organization

The Fraud Triangle

Personal Integrity and the Likelihood to Commit Fraud • The higher the personal integrity, the less likely to commit fraud. • Will take much more of the three fraud elements to move them to commit fraud. • Fraud studies show that levels of honesty are decreasing.

The First Element: Perceived Pressure 1. Financial 2. Vices 3. Work-related 4. Other

The Second Element: Perceived Opportunity The three components of perceived opportunity: 1. To commit fraud 2. To conceal fraud 3. To avoid punishment

Factors that Increase Opportunities to Commit Fraud 1. Ability to get around internal controls that prevent or detect fraud 2. Inability to judge quality of performance 3. Lack of an audit trail 4. Failure to discipline prior fraud perpetrators

Conditions that Create Opportunities for Fraud • Management not caring about honesty or ethics • Unreasonable Budget Expectations • Inadequate Pay • Short-Term Focus • Low Loyalty • Reactive vs. Proactive • Crisis Management • Hostile Work Environment • Poor Promotion Opportunities • Poor Training • Rapid turnover of key employees • • Absence of periodic rotations or transfers of employees Failure to inform employees about rules and discipline of fraud perpetrators • Lack of internal security • Familiarity with operations • Close association with suppliers and other key people • Absence of mandatory vacations

The Third Element: Rationalization • People rationalize their unacceptable behavior • Helps the fraudster hide from the dishonesty of the acts • Involved in nearly every fraud

Common Rationalizations • They owe it to me. • I’m only borrowing the money. • Nobody will get hurt. • I deserve more. • It’s for a good cause. • We’ll fix the books as soon as we get past this little financial problem. • It’s for my sick child.

Activities Fundamental to Fraud Prevention First: Create and Maintain a Culture of Honesty, Openness and Assistance

Activities Fundamental to Fraud Prevention Second: Assess the Risk of Fraud and Develop Concrete Responses to Minimize Risk and Eliminate Opportunity

Current Model for Dealing with Fraud 1. Fraud incident 2. Investigation 3. Action 4. Resolution

Actions Fraud Savvy Organizations Take to Minimize Fraud 1. Tone at the top 2. Education and training 3. Integrity risk and controls 4. Reporting and monitoring 5. Proactive detection

Tone at the Top Management and Directors • Backgrounds • Motivations • Influence on Decision Making

Tone at the Top (continued) Management’s Expectations 1. Appropriate Values & Ethics 2. Fraud Awareness & Training 3. Consistent Punishment of Violators

Education and Training • Prevention is the key! • Proactive fraud education – Employees – Vendors – Other outsiders

Integrity Risk & Controls • Implement effective internal controls – An ongoing task – Override of controls – Ignore controls • Learn from frauds that are detected – Implement controls to prevent future occurrences – Who was involved in the fraud? – Were controls compromised or were they absent?

Reporting and Monitoring • Most frauds are detected from tips • Employees must be alert to red flags that signal fraud • Employees must be willing and able to report potential fraud • Company should report fraud so that employees know that fraud does exist and it is THEIR problem, one they can prevent

Proactive Fraud Auditing/Detection 1. Identify risk exposures 2. Identify fraud symptoms for each exposure 3. Audit programs proactively look for symptoms and exposures 4. Investigate identified symptoms

Summary Keys to Fraud Prevention/Detection • “Walking the talk” – leading by example • Educating employees and others – they understand the problem and know what to do if they suspect fraud • Hotlines/Anonymous reporting mechanisms – potential fraud can be reported • Control procedures prevent and detect fraud • Fraud audits create fraud awareness – individuals know their work is always subject to review